“[I]f you’re willing to ignore short-term losses in individual bonds, why can’t you ignore short-term losses in bond funds?” – Ben Carlson, CFA
Investors have been worried about rising rates and what a rising rate environment means for their fixed income (bond) investments for quite some time now, a sentiment we echoed in our post around this time last year entitled Bonds In Bondage. In response, some investors have concluded that it is better to hold individual bonds in a rising rate environment versus a bond fund since individual bonds mature at which point (assuming no default) investors get their money back. In contrast, bond funds don’t mature because they are a perpetual investment vehicle and they fluctuate in price every day. In today’s post, we’ll unpack why it is a misconception to believe that individual bonds are somehow less risky than bond funds.
The myth that individual bonds are less risky than a bond fund is rooted in the fact that it is much easier to get daily prices on a bond fund than it is on an individual bond. As such, constant fluctuations in the price of a bond fund makes them feel “more risky” than simply holding individual bonds. But just because something is harder to price, doesn’t mean that it is less risky than something that publishes a price on a daily basis. The lack of price discovery simply makes it easier for investors to ignore any changes in the underlying value of their investment. But ignoring the fact that the value of an investment (in this case an individual bond) may be changing on a daily basis doesn’t mean that the value of the bond isn’t actually changing.
In fact, it is common practice for some less sophisticated, private fund sponsors to pitch us on the “benefit” of a stable price for their offering on the client’s statement. Although I’m sure some advisors may see this as a benefit because it reduces the overall anxiety level of their collective client base, it is nothing more than a red herring. Again, just because the actual market clearing price for any investment is either not updated or can be ignored, it doesn’t make that investment any less risky than those which publish prices on a more frequent basis.
Taking this back to the debate on individual bonds versus bond funds, as Ben Carlson wrote in the opening quote, “if you’re willing to ignore short-term losses in individual bonds, why can’t you ignore short-term losses in bond funds?” After all a bond fund is nothing more than a portfolio of individual bonds. How can the sum of the parts be more risky than the parts on their own? That flies directly in the face of a known principal of risk reduction called diversification.
Back in 2014 Cliff Asness, founder of AQR Capital and long-term quantitative hedge fund manager, penned an article in the CFA Institute’s Financial Analyst Journal entitled My Top 10 Peeves. Number ten was entitled Bonds Have Prices Too (How Do You Think We Price Those Bond Funds?).
Bond funds are just portfolios of bonds marked to market every day. How can they be worse than the sum of what they own? The option to hold a bond to maturity and “get your money back” (let’s assume no default risk, you know, like we used to assume for US government bonds) is, apparently, greatly valued by many but is in reality valueless. The day interest rates go up, individual bonds fall in value just like the bond fund. By holding the bonds to maturity, you will indeed get your principal back, but in an environment with higher interest rates and inflation, those same nominal dollars will be worth less. The excitement about getting your nominal dollars back eludes me.
Let’s unpack Cliff’s statement about “nominal dollars” with an example. Let’s say you invested $1,000 into a 10 year US Treasury note at today’s prevailing rate of 2.25% with the intention to hold the bond to maturity. Now let’s also say that for whatever reason (Fed Policy, economics, etc.) inflation, which currently sits around 2.0%, ticks up by 0.25% a year for the next 10 years. In nominal dollars (ignoring the impact of inflation), you will receive $22.50 in interest every year for 10 years for a total of $225 as well as a full return of your original $1,000 investment when the bond matures at the end of year 10 for a total payout of $1,225 on an investment of $1,000. But as we all know, inflation erodes the value of currency over time, so dollars 10 years from now are not as valuable as dollars today. After accounting for the effects of inflation, the real value of the interest payments in present day dollars gradually erodes over time.
To make matters worse, the biggest kick in the rear is the value of that $1,000 “nominal dollar” check the government writes you 10 years from now, which because of inflation is really only worth around $718 in today’s dollars. Adding up all the payments net of inflation, your $1,000 investment returned a grand total of $909.90 for a loss of $90.10 or 9.0%. Changes in inflation expectations and their impact on prevailing interest rates is why individual bond prices fluctuate between inception and maturity. Sure you can ignore those price fluctuations and yes, assuming no defaults, you will get your nominal dollars back at maturity, but that still doesn’t guarantee you a positive real return on your investment. So whether you hold a bond to maturity or buy and sell bonds on a more frequent basis such as bond fund manager, the risk of losing purchasing power due to rising inflation and interest rates remains.
Our hope is that after reading today’s post you are a better informed investor who understands that the risk of an investment has nothing to do with how often it reprices and everything to do with the underlying fundamentals of the investment. Inflation and rising interest rates are a real risk to consider, which is why we don’t want to put all our eggs in a fixed income or bond basket. Other investments such as equities (stocks) or hard assets (real estate or gold) have shown to be excellent stores of value in an inflationary environment, but each of them come with their own set of risks as well. This is why we emphasize a diversified approach to investing which includes not only stocks and bonds but also real estate, precious metals, and alternative investments with the goal of limiting the impact of any one particular risk factor on the portfolio. When you have this approach, you end up producing a much smoother return stream with fewer home runs, but also a lot fewer strike outs.
Author Elliott Orsillo, CFA is a founding member of Season Investments and serves on the investment committee overseeing the management of client assets. He spent nearly ten years as a financial analyst and portfolio manager working primarily with institutional clients prior to co-founding Season Investments. Elliott earned a bachelor's degree in Engineering from Oral Roberts University and a master's degree from Stanford University in Management Science & Engineering with an emphasis in Finance. Elliott and his wife Gigi have three children and like to spend their time outdoors enjoying everything the great state of Colorado has to offer.
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